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WebMemo #520 on Taxes

June 9, 2004

Sales Tax Deduction Would Subsidize Bigger Government, UndermineTax Reform

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The House of Representatives is considering a proposal to create a federal tax deduction for state and local sales tax-a preference that would be available only to taxpayers who do not utilize the deduction for state and local income taxes. This is bad policy. It would give governors and state legislatures an incentive to increase sales tax rates. It would do nothing to help the economy grow faster. Indeed, it would almost surely have an adverse impact because it would facilitate an increase in the burden of state and local government.

 

Advocates say that the current tax system is unfair since it allows a federal tax deduction for state and local income and property taxes. This is an accurate assertion. States that rely on sales taxes are disadvantaged by the current system. But two wrongs do not make a right. The best way to remove this inequity is to disallow special deductions for all state and local taxes, particularly income taxes. States would then be treated equally, and the internal revenue code would not be a tool to promote higher taxes at the state and local level. It is important to understand, though, that removing the special tax preference for state and local income taxes should not occur in a vacuum. Instead, because this reform would result in about $500 billion of higher taxes over a ten-year period, it should be linked to tax reforms that reduce tax revenue by a similar amount. Instead of trying to "make a right with two wrongs," this would be akin to killing two birds with one stone.

 

A new deduction for state and local sales taxes will create a new constituency against tax reform. This is especially unfortunate since lawmakers resisted special interest pleading in 1986 and eliminated the preference. Indeed, it is worth noting that there were no adverse consequences-either economically or politically-stemming from this decision. Reinstating the deduction would be an unfortunate digression.

 

Subsidizing bigger government

Tax preferences have an adverse impact by shielding taxpayers from the real cost of certain activities, and there are two reasons for the damage. First, preferences encourage individuals to "demand" more of the sheltered activity, thus diverting resources from more productive uses. The home mortgage interest deduction, for instance, is widely believed to harm the economy by encouraging people to shift money from business investment to residential housing. Second, preferences enable providers to "capture" part of the tax preference by increasing prices. Most experts believe, for example, that education tax credits lead to higher costs as colleges adjust their tuition prices to get a share of the money.

 

Allowing a deduction for state and local taxes would have these effects-and the result would be bigger government. Consider a hypothetical taxpayer with a middle-class income, someone who is in the 25 percent federal tax bracket. Under current law, if this taxpayer pays $500 of sales tax to his state government, he has a $500 incentive to make sure that his state lawmakers are being responsible. He expects $500 worth of services and will agitate for smaller government if he feels his money is not being well spent. But if the state sales tax is deductible, his federal tax bill will drop by $125, which means that $500 of state sales tax only reduces his disposable income by $375, thus making state government seem less expensive that it really is. As a result, taxpayers have an incentive to seek more government.

 

Not surprisingly, state politicians take advantage of this illusion. They understand that deductibility shields taxpayers from the full burden of tax increases and that this makes it easier to increase the size of government. Under current law, for instance, our hypothetical taxpayer's disposable income drops by $100 when the state sales tax climbs by $100. But if the state sales tax is deductible, a $100 sales tax increase reduces his disposable income by only $75. The "cost" of the tax increase is reduced, with the size of the decrease depending on each taxpayer's tax bracket. This does not eliminate opposition to tax increases, but it does reduce the intensity of resistance and thus facilitates the growth of state government.

 

Undermining tax reform and economic growth

A key principle of tax reform proposals such as the flat tax is neutrality-the notion that the internal revenue code should not grant special preferences or impose special penalties based on the source of income, the use of income, or the level of income. Such policies distort the economy by giving taxpayers a reason to make decisions based on tax considerations rather than the economic merits.

 

Deductions for state and local taxes are a perfect example of the adverse economic impact of social engineering and industrial policy in the tax code. They shield taxpayers from the cost of government, thus luring people to be less vigilant against government expansion while making it easier for politicians to expand the size of state and local government.

 

A bigger government sector necessarily means a larger burden on taxpayers. Resources will be misallocated as money shifts from the productive sector of the economy to the government. Nations with bigger governments grow slower than countries with smaller governments, and states with bigger governments grow slower than states with smaller governments. This is why jurisdictions with smaller governments like the United States, Ireland, and Hong Kong enjoy better performance than high-tax welfare states like France, Germany, and Sweden. It is also why states like New Hampshire, Nevada, Florida, and Texas out-perform states like Massachusetts, New York, and California.

 

The right approach

The strongest argument in favor of sales tax deductibility is the inequitable treatment of states that rely on the sales tax rather than the income tax (local governments tend to utilize property taxes). Current law allows the deductibility of state and local income and property taxes, but does not permit any deduction for sales tax. This is an unfair approach, and it is especially perverse since it encourages states to utilize a revenue source-the income tax-that has the most adverse impact on economic performance.

 

But rather than add another loophole to the tax code by making the sales tax deductible, lawmakers should repeal existing preferences for other forms of state and local taxation. Such a step would remove distortions from the tax system and boost the economy by encouraging a more efficient allocation of resources.

 

That is the good news. The bad news is that the elimination of deductibility would be a big tax increase. According to the Treasury Department, repealing the existing deductions for income and property taxes would increase federal tax collections by more than $50 billion annually. This would be the wrong approach because more money in Washington would further weaken the already tenuous commitment to control federal spending.

 

This is why deductibility should be eliminated only as part of a meaningful tax reform so that the $50 billion-plus of revenue can be used to implement pro-growth tax reforms. There are a number of attractive options, including:

  • Repeal of the alternative minimum tax - The AMT is a pernicious tax that-left unchanged-will force millions of additional taxpayers to compute their taxes twice and then pay the government whichever amount is larger. This tax should be repealed.
  • Repeal of the double-tax on dividends and capital gains - Policy makers took an important step in the right direction last year by lowering the tax rate on dividends and capital gains to 15 percent, but the correct rate to eliminate the tax bias against capital formation is zero.
  • Universal individual retirement accounts - IRAs also have been expanded in recent years, thus helping taxpayers protect themselves from double-taxation. These provisions should be made universal so that no Americans are double-taxed simply because they save.
  • Territorial taxation - The United States imposes a perverse form of double-taxation on income earned in other nations. This policy of "worldwide taxation" is unfair since other nations already tax that income. Lawmakers should shift to territorial taxation, the common-sense notion of taxing only income earned inside national borders.
  • Corporate tax rate reduction - America's 35 percent corporate tax rate is the second highest in the industrialized world, higher even than those in welfare states like France and Sweden. The United States should learn a lesson from Ireland, which has turned itself from the "sick man of Europe" into the "Celtic Tiger" by slashing the corporate tax burden.

There are many other supply-side tax reforms that would be beneficial, including reductions in the 35 percent top personal income tax rate and a reduction in the tax penalty on new investment by shifting from "depreciation" to "expensing." There are strong arguments for all these proposals, but the real point is that the tax code would be more conducive to growth if any of these reforms were combined with an elimination of the deductibility of state and local taxes.

 

As a final note, eliminating the state and local tax deduction is a proposal that should appeal to leftists because it would get rid of a loophole that benefits the rich. Nearly 9.3 million taxpayers with annual income over $100,000 enjoy aggregate tax savings in 2003 of almost $30 billion because of the deductibility of state and local taxes. By contrast, only 63,000 taxpayers with less than $10,000 of income benefited, and their total tax relief was only $1 billion. Indeed, taxpayers with income of more than $100,000 receive more than twice the benefit of all other taxpayers combined. Tax policy should never be based on distribution tables, which are one-time snapshots that fail to measure economic effects, but since the state and local tax deduction is a loophole for the rich that harms the economy, there might be a chance for a "strange bedfellows" alliance between left and right.

 

Conclusion

By considering a proposal to make sales tax deductible, Congress is moving in the wrong direction. To be sure, the specific proposal requires taxpayers to choose either sales tax deduction or income tax deduction. And the proposal also is effective for only a two-year period. These factors will ameliorate the negative effects of expanded deductibility. Nonetheless, it is unfortunate that this proposal is even on the table, particularly when there is a much better approach.

 

Daniel J. Mitchell is McKenna Senior Fellow in Political Economy at The Heritage Foundation.

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